10 tips on how to manage sales tax compliance

This may seem like a no-brainer, but too often companies get in trouble or complicate the audit process with basic errors in how they calculate or report sales and use tax. Once an auditor starts seeing these mistakes, it signals to them they need to probe further, and that can change the audit process dramatically.

If you have doubts, it may pay to bring in a CPA who specializes in state and local taxes to assess your tax liabilities. In particular:

Know where you have nexus: Do you have a significant physical or economic presence in a state where you’re not currently registered or collecting? Each state has different requirements.

Understand the requirements for each jurisdiction: Because they vary from state to state, review each state’s rules for specifics like electronic filing requirements, advance payments, and certain forms.

Forget about ZIP codes: ZIP codes are the wrong tool for accurately calculating sales tax rates.

Pro tip: Show your work 

Former California state auditor Mehrdad Talaifar says “companies don’t always get in trouble because they managed sales tax wrong, but because they can’t produce reports that prove they’re doing it correctly. It’s a good idea to retain ‘internal’ tax return worksheets that substantiate the source of reported figures. They are an extremely valuable resource in recalling audit trails, particularly after a number of years have elapsed.”

Conducting a pre-audit or reverse audit before you get a notice from a state lets you find and correct your own errors. You could have your own team do it but outsourcing this task to a consultant has its advantages in that you’re bringing in a fresh set of eyes. Either way, catching and correcting your own errors is worth the effort and can pay off in reduced future penalties, and makes a difference for partners and investors.

Pro tip: Be ready for questions

Former California state auditor Steven Cabrera says that while you “can’t change recorded history,” auditors may have questions: “Be able to explain ‘adjustments’ such as credit memos, errors, etc. You have to show proof that everything was eventually taxed correctly.”

Inconsistent accounting practices give auditors reason to investigate further. They’ll want to know why you had one workflow for determining tax compliance on one set of transactions, but a different workflow for another.

These inconsistencies can creep in for the most innocent of reasons. Perhaps your accounting manager was out for a few months, so you brought in a temp who used a slightly different accounting method. Or perhaps you’ve adopted new accounting software or even a new ecommerce platform that generated different reports.

It pays to do your own internal audit whenever one of these events occurs.

Pro tip: Outliers are your enemy 

Former California state auditor Clifford Turner says auditors “don’t look for how many transactions were done correctly, but for any records that stick out from the rest.”

You’re legally bound to give certain information to the auditor if they ask for it. So just give it to them. Don’t withhold it or create unreasonable delays, and make sure your records are easy for them to review.

Don’t make it seem like you’re hiding anything. This makes auditors dig deeper and work harder to find potential discrepancies or errors.

On the flip side, don’t overshare either. Don’t give them records they didn’t ask for; this complicates the process and opens the door for miscommunication.

Two rules to remember: Ask for all information requests to be made in writing, and don’t put people in the room with an auditor. Both help cut down on miscommunication that could make the auditor dig a little deeper.

Pro tip: More is not better

Former Texas state auditor Sylvia Aguirre says “compiling additional information doesn’t give the desired effect of showing due diligence or flawless accounting. It only incites more questions.”

Our experts had some stories to tell: One company being audited gave them a couch to work on, seated next to a huge Great Dane that drooled all over the paperwork. Another company put an auditor in a van parked curbside in the blistering summer sun.

Nobody likes getting audited, but don’t take that out on the auditor. These conditions put auditors in a bad mood and can result in them going the extra mile to find more errors and request more information.

Two recommendations:

First impressions matter: Show up with a smile, act professionally, and make time for the auditor. Talk through the process together so you have shared expectations.

Make the auditor comfortable: Find a place for them to work that’s well lit and conducive for getting work done.

Pro tip: Be nice but not too nice

Talaifar says while you should put them at ease, “don’t make things too comfortable for the auditor. You want to make sure they have enough reason to leave.”

Mismanaging use tax is one of the costliest compliance mistakes companies make. State auditors say they’re the No. 1 audit risk and the bulk of assessments come from use tax not being paid. Certain industries — namely manufacturing, construction, and hospitality — face even greater risks, because the use tax rules for those businesses are more complex and vary state to state.

How you “consume” certain items in your business is often a determining factor. Common triggers include, but are not limited to:

• Inventory transfers
• Promotional giveaways (which can include free samples to customers) 
• Charitable donations
• Purchases of fixed assets where tax was not collected by the vendor
• Withdrawal of inventory for internal research and development (in certain states)

If these items were intended for resale and you didn’t pay sales tax at the time of purchase, then you’re likely obligated to pay use tax. If you bought equipment or furniture for your office then moved locations, and the tax rate is higher in the new location, you may owe the difference in use tax. 

This is where most auditors spend their time. This is also a good place for you to seek counsel.

Pro tip: Don’t assume your suppliers are doing it right.

Cabrera says that just because a vendor or supplier doesn’t collect sales tax on a transaction “don’t assume they are doing it right. Check the purchase invoices carefully, if they are subject to tax. If the purchase is subject to tax, the conservative approach is either have the seller collect the tax or self-report the use tax.”

Any company that sells multiple products and services into multiple states has an administrative nightmare when it comes to managing and storing tax exemption certificates. If a tax exemption certificate is invalid, out of date, or missing, a company can be liable for the sales tax not collected, even if the sale was to a tax-exempt organization. In addition to the unpaid taxes, you also could see penalties and fees.

If you’re missing one exemption certificate, you might end up on the hook for many. (To learn more, read our sales tax exemption certificate survival guide.)

Pro tip: Do an audit of your certificates on file

Aguirre says exemption certificates are a good place to start when you’re doing your own self-audit. “That’s the area an auditor will likely start with,” she said. “Missing or outdated exemption certificates on transactions will blow any chance of a quick and painless audit.” 

Before starting the audit, you can negotiate the following:

Start date: You want substantial lead time to prepare – at least a month. Don’t hesitate to ask.

Date range: If there have been improvements in your business practices for monitoring the taxability of purchases, ask for an audit period that comes after the process improvements were made.

Missing documentation: Inevitably there will be missing documents, such as invoices. Will the auditor allow you to substitute a like invoice to prove tax was paid? If exemption certificates are missing, will you be given time to gather them?

Pro tip: Don’t sign if you don’t know

Turner says audits come with a lot of legal forms to sign. “If you don’t know what you are signing, seek out help. Once you sign the document, it can’t be rescinded.”

There are a number of factors that make some companies more likely to be audited than others. Some businesses are targeted because of their size, sales volume, or the complexity of their returns, or because of a specific event, like a bankruptcy filing or an acquisition.

One of the biggest factors states look at is whether the company has been audited before and the outcome of that audit. Here are some others:

High volume of exempt sales: Also, claiming frequent refunds or large tax credits can be a red flag for auditors.

Errors on filed returns are red flags that can trigger an audit. 

Late filing taxpayers will be scrutinized and eventually audited.

Sole proprietors are audited more frequently than small business corporations because sole proprietorships historically have more errors in their self-prepared returns.

Audits of customers: If you failed to correctly collect tax from a customer, that may be detected when your customer is audited. This could lead to an audit for you.

Whistleblowers: Competitors or even employees have been known to contact state tax departments. 

Pro tip: Best offense is a good defense

Cabrera says that “when you manage sales tax correctly, such as employing internal controls and conducting periodic self audits before you get audited, you have less to worry about when your name comes up.” If you’ve had a prior audit, he adds, “ensure that you have corrected errors found in that audit.”

Relying on institutional knowledge and manual processes often creates errors, particularly if you have staff turnover. That can be costly: The average cost of an audit is more than $300,000, according to Wakefield Research. 
 
Automating your compliance functions eliminates much of the laborious work of sales and use tax management — and it can help protect against adverse audit filings. Automated solutions also improve efficiency by assessing, calculating, and accruing sales and use tax when invoices are originally processed.

Learn more about how automated solutions like Avalara AvaTax can help your business spend less money on sales tax compliance. 

Mehrdad Talaifar is a recognized expert in sales, use, and value-added tax compliance automation with more than 30 years of indirect tax experience. He was a California state auditor and held leadership roles in the private sector.

Sylvia Aguirre is co-founder of Avalara CertCapture and an expert on exemption certificate management. She has more than 20 years of experience in sales and use tax compliance and is a former Texas state auditor.

Clifford Turner is a former California state tax auditor and an industry veteran with more than 25 years of sales and use tax experience, including tax compliance management roles at two of the Big Four accounting firms.

Steven Cabrera is a CPA and former California state tax auditor with more than 20 years of sales and use tax experience both in state government and the Big Four accounting firms.

Avalara provides more than sales and use tax compliance, it also gives businesses a powerful solution to manage invoicing, bill pay, and cash flow in one place. With Hopscotch by Avalara, businesses can create and send invoices, collect payments, and avoid transaction fees with fee-free bank transfers. Hopscotch integrates with accounting software like QuickBooks to automatically reconcile payments. You can even use it to skip net invoice terms altogether and get paid instantly. Learn more.

This post has been updated; it was originally published January 20, 2022.